Week-4
FINC 5880
Dr. Ahmed
Name __________
Types of hybrid securities
Preferred stock
Warrants
Convertibles
Features and risk
Cost of capital to issuers
Preferred Stock
Dividends (Cumulative, Before common Dividends)
Perpetual
Limit maturities
No voting rights
Board of Directors (may be)
Advantages
Dividend obligation not contractual
Avoids dilution of common stock
Avoids large repayment of principal
Disadvantages
Preferred dividends not tax deductible, so typically costs more than debt
Increases financial leverage, and hence the firm’s cost of common equity
Dividends are indexed to the rate on treasury securities instead of being
fixed.
Excellent S-T corporate investment
Only 30% of dividends are taxable to corporations.
The floating rate generally keeps issue trading near par.
Warrant
A warrant is a long-term call option.
A convertible consists of a fixed rate bond (or preferred stock) plus a long-term
call option.
Given the following facts, what coupon rate must be set on a bond with warrants if
the total package is to sell for $1,000?
P0 = $20.
Cost of Debt (rd) of 20-year annual payment bond without warrants = 12%.
50 warrants with an exercise price of $25 each are attached to bond.
Each warrant’s value is estimated to be $3.
Step 1: Calculate Value of the Bond
VPackage = VBond + VWarrants = $1,000.
VWarrants = 50($3) = $150.
VBond + $150 = $1,000
VBond = $850.
Step 2: Find Coupon Payment and Rate
N= 20 , I/Y = 12 , PV= -850
, PMT = ? , FV= 1000
Rate = ($100/$1000) = 10%
If after issue the warrants immediately sell for $5 each, what would this imply about the
value of the package?
At issue, the package was actually worth
VPackage = $850 + 50($5) = $1,100, which is $100 more than the selling price.
Will the warrants bring in additional capital when exercised? YES
Because warrants lower the cost of the accompanying debt issue, should all debt be
issued with warrants? NO
What is the expected return to the bond- with-warrant holders (and cost to the
issuer) if the warrants are expected to be exercised in 5 years when P = $36.75?
The company will exchange stock worth $36.75 for one warrant plus $25.
The opportunity cost to the company is $36.75 - $25.00 = $11.75 per warrant.
Bond has 50 warrants, so the opportunity cost per bond = 50($11.75) = $587.50.
Time Line:
Y0= +$1,000, Y1-20= - $100, Y5= -$587, Y20= -$1,000
Compute IRR = 14.7%
The cost of the bond with warrants package is higher than the 12% cost of straight debt
because part of the expected return is from capital gains, which are riskier than interest
income. The cost is lower than the cost of equity because part of the return is fixed by
contract.
When the warrants are exercised, there is a wealth transfer from existing stockholders to
exercising warrant holders.
But, bondholders previously transferred wealth to existing stockholders, in the form of a
low coupon rate, when the bond was issued.
At the time of exercise, either more or less wealth than expected may be transferred from
the existing shareholders to the warrant holders, depending upon the stock price.
At the time of issue, on a risk-adjusted basis, the expected cost of a bond-with-warrants
issue is the same as the cost of a straight-debt issue.
Assume the following convertible bond data:
20-year, 10.5% annual coupon, callable convertible bond will sell at its $1,000 par value;
straight debt issue would require a 12% coupon.
Call protection = 5 years and call price = $1,100.
Call the bonds when conversion value > $1,200, but the call must occur on the issue date
anniversary.
P0 = $20; D0 = $1.48; g = 8%.
Conversion ratio = CR = 40 shares.
What conversion price (Pc) is built into the bond?
=
($1,000/40) = $25
What is (1) the convertible’s straight debt value and (2) the implied value of the
convertibility feature?
N= 20 , I/Y = 12 , PV= ? , PMT = 105 , FV= 1000
= -$887.96
Because the convertibles will sell for $1,000, the implied value of the convertibility
feature is
$1,000 - $887.96 = $112.04.
The convertibility value corresponds to the warrant value in the previous example.
What is the formula for the bond’s expected conversion value in any year?
Conversion value = CVt = CR(P0)(1 + g)t.
CV = Conversion Value
CR= Conversion Rate
P0 = Stock price at period zero
G= growth rate
t= time period
t=0
CV0
= 40($20)(1.08)0 = $800.
t = 10
CV10 = 40($20)(1.08)10 = $1,727.14.
The floor value is the higher of the straight debt value and the conversion value.
Straight debt value at period 0 = $887.96.
CV at period 0 = $800.
Floor value at Year 0 = $887.96.
Straight debt value10 = $915.25.
CV10 = $1,727.14.
Floor value10 = $1,727.14.
A convertible will generally sell above its floor value prior to maturity because
convertibility constitutes a call option that has value.
What is the convertible’s expected cost of capital to the firm?
Does the cost of the convertible appear to be consistent with the costs of debt and
equity?
For consistency, need cost of debt (rd) < cost of convertibles(rc) < cost of equity (rs).
Why?
WACC Effects
Convertibles Step 1: Find the after-tax cost of the convertibles.
Convertibles Step 2: Find the after-tax cost of straight debt.
Convertibles Step 3: Calculate the WACC.
Warrants Step 1:
Find the after-tax cost of the bond with warrants.
Warrants Step 2:
Calculate the WACC if the firm uses warrants.
Issues:
We have assumed that rs is not affected by the addition of convertible debt.
In practice, most convertibles are subordinated to the other debt, which muddies our
assumption of rd = 12% when convertibles are used.
When the convertible is converted, the debt ratio would decrease and the firm’s financial
risk would decline.
Besides cost, what other factors should be considered?
The firm’s future needs for equity capital:
Exercise of warrants brings in new equity capital.
Convertible conversion brings in no new funds.
In either case, new lower debt ratio can support more financial leverage.
Does the firm want to commit to 20 years of debt?
Convertible conversion removes debt, while the exercise of warrants does not.
If stock price does not rise over time, then neither warrants nor convertibles
would be exercised. Debt would remain outstanding.
Recap the differences between warrants and convertibles.
Warrants bring in new capital, while convertibles do not.
Most convertibles are callable, while warrants are not.
Warrants typically have shorter maturities than convertibles, and expire before the
accompanying debt.
Warrants usually provide for fewer common shares than do convertibles.
Bonds with warrants typically have much higher flotation costs than do convertible
issues.
Bonds with warrants are often used by small start-up firms. Why?